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How to Use On Balance Volume (OBV)
09/24/2009 1:56 pm EST
How often have you found a very clear chart pattern, waited patiently and established a position, only to be quickly stopped out as the breakout turned out to be false? Though it has happened to all of us, in many cases, careful analysis of the volume patterns would have kept you out of the trade. If you analyze the trades you have made in the past year, I believe you will find that if you could have avoided just 10% of your trades, the performance would have been greatly improved. Trading strategies that can help you be more selective in the trades you take may be the key to dramatically improving your trading performance.
From previous articles, it should be clear that I find careful analysis of chart patterns essential to any trading strategy. If you do not look at the volume in conjunction with the patterns, you may miss some valuable clues. Any time a market, stock, or commodity makes a new high or a new low, I want to know whether the volume confirmed the new highs or new lows. In other words, to keep a market bullish, you would want to see that new highs are accompanied by equal or higher volume than the previous high. This will tell you that new buyers are likely coming into the market. Conversely, if a market is declining, lower volume on new lows will give the trader an indication that the majority has already sold. Of course, looking at more than one consecutive trading period can give you added confidence.
The chart above (Figure 1) shows the weekly price activity of the QQQQ, an ETF that mirrors the Nasdaq 100. You will note that as the QQQQ continued to make new lows in July 2002, point 1, the volume continued to expand, hitting a high of 7.34 million shares the week of July 26, 2002. After rebounding for a few weeks, the decline resumed, making a series of new lows in September and finally bottoming in early October, point 2. The volume was about 30% lower on this decline and it shows a pattern of lower highs (line A), suggesting that selling pressure was not as heavy as it was in July.
When trying to determine whether the overall market is making an intermediate turn, it is beneficial to get confirmation from all sectors. The weekly chart, Figure 2, of the S&P depository receipts (SPY), based on the S&P 500, illustrates that when the July lows were violated in October (line a), volume was less than on the previous low (line b). As the SPY drifted back towards these lows in February and March of 2003, volume was even lower (circle c). Therefore, the selling pressure was also decreasing in the S&P 500, supporting the analysis of the Nasdaq, which suggested the market was bottoming.
Since the early 1980s, one of my favorite volume indicators has been the On Balance Volume (OBV), developed by Joseph Granville, one of the earliest, and more flamboyant market technicians. He developed it as a way to determine whether the smart money was buying or selling. It is calculated by keeping a running total of the volume figures and then adding in the volume if the close was higher than the previous period, or subtracting the volume if the closing price was lower. If you are doing this in a spreadsheet, such as Excel, the starting volume can be arbitrary, as it is the pattern of the OBV, not the absolute number, that is important. When viewed on a weekly basis, it can be very useful in spotting major turning points. The analysis of the OBV on the major currencies in the spring of 1985 was instrumental in helping me identify the major top in the dollar, despite fundamental opinions and evidence to the contrary.
NEXT: Several Effective Ways to Analyze OBV |pagebreak|
There are several ways that the OBV can be analyzed. The first is to determine whether the OBV is acting stronger or weaker than prices and then also to look for divergences between the OBV and prices. I feel that the OBV analysis can be clarified by running a 21-period weighted moving average (WMA) on the OBV. When the OBV is above its WMA, it is positive, and when below it, it is negative. The slope of the 21 WMA is also important, as is trend-line analysis on the OBV. As with many technical tools, fewer signals are given when using weekly data, rather than daily data. Figure 3 shows the weekly chart of the Nasdaq ETF with the OBV and its 21-period WMA. The OBV dropped below its WMA in January 2002 (point 1) and then rebounded almost to the now-declining WMA before heavier selling hit the market. The OBV stayed below its WMA until late-October (point 2), when the OBV was able to move back above its flattening WMA. There were no clear-cut divergences between the OBV and prices at the lows, but in my experience, this is not unusual. From October 2002 and May 2003, the OBV formed a trading range, moving above and below its WMA several times. The breakout above resistance, line a, in May (point 3), confirmed that the bottom was in place.
The OBV is one of my favorite indicators to use on individual stocks and is one of the first indicators I look at when deciding whether to buy or sell a stock. Freeport McMoran Copper & Gold (FCX) is a widely followed stock that made its lows in late 2008 at $15.70. The weekly OBV had dropped below its WMA in June 2008, point 1, when FCX was trading around $108, and did not start to bottom out until early 2009 as it formed higher lows, line c. The OBV did not form any positive divergences, but it was easy to identify a clear level of OBV resistance that I have labeled line b. This resistance and its WMA were both overcome the week ending February 7, 2009 (point 2), giving a strong signal that the lows were in place. Two weeks later, the OBV pulled back slightly, but held above the rising WMA, which created another entry opportunity. In July, the OBV dropped below its rising WMA (point 3), but held well above its uptrend and the previous lows. A look at the daily chart provided further evidence that this was a correction and nothing more.
The daily OBV pattern also supported the conclusion that FCX was bottoming. The daily OBV edged above its WMA in late-December of 2008. By the early part of January, point f, the OBV was acting stronger than prices and was in a solid uptrend. During this period, FCX was still stalled below the resistance at $31. The close on March 4 above this resistance was supported by the OBV as it was acting stronger than prices, reflecting accumulation. The OBV continued to move higher, peaking in mid-March and then developed an upward-sloping trading range. The OBV did confirm the June highs that preceded a sharp correction, which corresponded to the drop in the weekly OBV below its WMA that was mentioned previously. The correction bottomed in early-July as FCX held above both the chart support, line c, and the 38.2% retracement level. Later in July, the OBV broke out to new highs, point g, which forecasted still higher prices.
MORE: OBV Applied to Daily/Weekly Charts of STX |pagebreak|
The RS analysis on the technology sector turned positive in late-February 2009, and Seagate Technology (STX) was another stock that I purchased (and still own) because of the strong OBV signals. The weekly chart shows that the OBV formed a positive divergence at the lows, line b, and then moved strongly above its WMA in late-March, part 1. The longer-term OBV resistance, line a, was overcome in April, and the OBV has continued to confirm each new high. As one would expect, the daily studies gave bullish signals a bit earlier than the weekly data. The bullish divergence, line c, is a bit more pronounced, and the downtrend in the OBV, line c, was broken on March 24, at point 2. The daily OBV continues to make new rally highs, confirming higher prices.
Some technicians may not favor the OBV because they have a problem with how OBV is calculated since all the volume is added in or subtracted out depending on the whether the close is higher or lower. In their view, this fails to acknowledge that some of the volume would be on the other side. While I can accept their concerns from a theoretical standpoint, I have used the OBV for over 20 years and know that it gives me some of the most reliable signals, especially using weekly or monthly data. Some of you will recall that a bullish stance on gold has been warranted over the past few years, in part, because the monthly OBV has been leading prices higher. I hope you will take a hard look at incorporating the OBV into your analysis, and please feel free to e-mail me with any questions or comments at TomAspray@moneyshow.com.
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